It’s important, when evaluating a potential pre-construction investment, to have a general understanding of the anatomy behind such deals.  Particularly, it’s wise to understand the role of the developer and their needs; their needs will affect your needs as an investor.  Since I believe this is important, this article will cover pre-construction deals from a developer’s perspective.

Summed up simply, a developer needs to sell properties to secure a paycheck.  Driving each decision is this need to sell their pre-constructed properties to cash in on payday.  This is why investors are incredibly attractive to developers—they have the ability to turn a developer’s vision into a profitable reality. 

Here’s where things can go a couple of different ways depending on the type of developer you’re working with: Are you working with a reputable developer who wants to work collaboratively with investors or are you working with a developer who’s goal is to make a deal appear attractive while maximizing their profit margin? 

Let’s look at how both types of pre-construction deals could play out.

First, consider you’re an investor working with an upright developer.  (Take a moment to celebrate because you could potentially make a very wise investment).  Usually, but not always, a developer like this is looking to get their project started and needs investors to gain momentum.  This very need motivates developers to share their net profit with the investors, allowing these investors to purchase the pre-constructed homes at a true discount.  For example, let’s say a home’s true market value is 160K, but after building costs, selling and interest fees, the net profit per home is 20K.  Most developers will split this profit with an investor, selling the home to them for 150K, still making 10K per lot.  Both the motivated developer and the wise investor win.

The key component in this equation is an accurate market value.  This is where a developer who’s concerned with maximizing profit, even at another’s expense, can create a crooked deal that puts a lot of money in their pocket.  All these developers need to achieve a generous spread is to get a couple of appraisals suggesting an inflated market value.  Using the same hypothetical pre-constructed home above, what would happen if the developer could convince an investor that the home is worth 185K?  In this situation, the net profit for the developer is 45K.  If they give the same deal as above, a 10K discount, they make 35k per home instead of 10K.

As illustrated above, a developer and investor can have a beautifully mutually beneficial relationship.  But, a less-than-reputable developer can leave investors in their wake who could potentially owe more on their investment than it’s worth.